Market expectations for US economic growth have continued to ratchet lower in recent weeks as the main cyclical indicators (the ISM and non-farm payroll) have disappointed yet again. This is the fifth time in the past six months the ISM has been weaker than the market had hoped and the fourth time for the payroll data over the same period.
Market interest rate forecasts have now fallen too close to our own for us to claim to be materially below consensus any longer (3.50 per cent peak in Fed Funds in August is our call versus a 3.75 per cent estimated peak foreseen by the futures markets).
Near-term it is hard to see much further progress being made. Further out, we still believe some disappointment is likely from the economic newsflow over the second half.
In the very near-term, the extent of macro disappointment is more likely to recede than accelerate. With indicators of labour market activity, from jobless claims to wages growth, still consistent with reasonable levels of labour demand right now, last month’s 78k payroll number looks too low.
Similarly, the very recent path of the ISM manufacturing index has probably been distorted to the downside as a consequence of firms adjusting to an excessive inventory build-up earlier in the year.
With that in mind, there should be some respite from the gloom in the coming weeks. The economy’s medium-term prospects, according to longer lead indicators such as the change in the yield curve and in monetary policy, is for a continuation of the slowdown through much of the first half of next year. Using these conventional longer lead indicators there is no end in sight to the economy’s deceleration.
Moderate growth outlook
Indeed, if Fed policy tightening continued along the quarter point per meeting path through the second half of this year then we would consider it quite likely that GDP growth would fall throughout 2006. But given that we expect the Fed to stop raising interest rates at 3.5 per cent at the August FOMC meeting, our growth outlook is more moderate.
With the monetary impulse turning more favourable (by the Fed staying put from August) we’d expect economic growth to reach a trough in the first half of next year.
In the meantime, one consequence of the market’s recent moves is to reduce mortgage borrowing rates. The latest Treasury market rally has pushed 30-year mortgage rates down to 5.55 per cent.
A couple of points to note – firstly, there is a very close correlation between changes in the 30-year mortgage rate and the number of refinancing applications. Secondly, significant refi activity is sparked only when the mortgage rate reaches new lows.
So while we are just a few more basis points away from reaching yields consistent with another reasonable amount of refi activity, there is a further 60bps to go before a major uplift to borrowing (and therefore consumption) could be expected. And with short-term rates now significantly higher, revisiting the June 2003 lows looks very tricky indeed.
Key developments
The Bank of England MPC left interest rates unchanged at 4.75 per cent at its June policy meeting – the tenth consecutive month of steady policy. Our central expectation remains that the MPC will cut rates to 4.5 per cent near the end of this year (November being our best guess at the moment). Financial markets have now overtaken us and predict a cut sooner rather than later with a good chance of a further move down to 4.25 per cent well on the way to being priced in. The coming weeks should see some of this move being retraced. Critical to our view is the notion that the consumer isn’t under quite as much downward financial pressure as is seemingly reflected in the dire warnings from retailers. And the principal driver of this view is that household income growth is still at reasonable levels. If we are right, there should be some abatement in the negative consumer newsflow in the coming weeks. While the level of mortgage approvals remains fairly low – 95k in April compared with the peak in November 2003 of 113k – it is hardly at levels consistent with profound housing market weakness. As important, the downward momentum in borrowing, which accelerated throughout the second half of last year, has turned around with 5 consecutive monthly gains being seen since November 2004.
With the initial absorption of the EU Constitution’s rejection now passed, the euro has been little changed on the foreign exchanges in the past week, remaining around 1.22 versus the US dollar. As we outlined recently, we don’t believe the deleterious impact upon the currency will be long-lasting nor has it been all that significant up to now (compared with average exchange rates over the past few years or on a trade-weighted basis). More important for the economy, and the ECB, at the moment is the virtual absence of any upward growth momentum from domestic demand. Euroland growth indicators are deteriorating, principally because of fading external drivers, while domestic indicators continue to flatline.
